The basic decision rule in terms of cost-benefit analysis requires that benefits and costs be expressed in monetary units for each period of time over the economic life of the project, and that these values be discounted by some chosen SDR to obtain a net present value of social benefits.
IN ORDER that this decision rule be consistent with the objective function of maximizing social welfare, it is necessary that the prices attached to the physical benefits and costs reflect society?s valuations of the final goods and resources involved. Two questions immediately arise:1. If markets do exist, to what extent will observed market prices reflect social valuations?
If markets do not exist, how are surrogate prices to be derived which, in turn, reflect social valuations. Whatever society's objective function is, there will be a sacrifice involved in applying resources to one use rather than another. The relevant price for cost-benefit purposes is therefore the price which reflects this opportunity cost.
There exists, then, some set of prices, called 'shadow' or 'accounting' prices, which reflect the true social opportunity costs of using resources in a particular project. These shadow prices are not necessarily observed in actual market behaviour. As their name implies, they exist rather like Plato's universals.
Actual market prices may or may not approximate these shadow prices. In general we would expect the marginal cost of a final good to indicate society's valuation of that good, since the marginal cost reflects consumers' willingness to use resources in that use. As a first approximation, then, shadow prices are indicated by marginal costs.
A further problem exists in that profit-maximizing concerns will not take account of the third-party effects of their actions. That is, they will ignore external costs and benefits. To the extent that they do this, the prices charged for their goods will not reflect true social costs. The argument of the preceding paragraph can therefore be restated. Shadow prices should reflect marginal social costs rather than marginal private costs.In practice, prices are not likely to reflect either marginal private cost or marginal social cost, owing to the existence of imperfectly competitive markets and external effects. It follows that market prices should, for valuation purposes, be adjusted to reflect marginal costs. It has been suggested that, for the U.S. economy at least, final-good prices do not diverge significantly from marginal costs, and that what divergence there is merely reflects consumers? preferences for product differentiation.
There is some cause here, then, for not worrying with adjustments to market prices, although failure to make such adjustments does imply at least partial rejection of Pareto optimality conditions.A somewhat more serious problem concerning the use of marginal costs (private or social) as shadow prices for final goods is that optimality conditions will only be met if all final goods are priced at marginal cost. The use of marginal-cost pricing in the public sector with prices elsewhere diverging from marginal costs involves the ?second best? problem.
The essential argument is that setting prices equal to marginal cost in one sector only may actually move the economy away from a Pareto optimum. At the very least, such a policy cannot guarantee a move towards an optimum. In other words, given that a ?first best? is not achievable (prices equal to marginal costs everywhere), marginal-cost pricing in the public sector will not guarantee a ?second best? (i.e. the best available position given that a first best cannot be secured). Although there have been a number of criticisms of the Lipsey?Lancaster theorem, its general conclusion still holds. Cost-benefit theorists have been notable, in the main, for their failure to acknowledge the problem.
As Margolis has remarked, ?these arguments are referred to in footnotes and then ignored?.Clearly, if market prices are to be corrected so that they reflect marginal costs, there is a practical problem of estimating marginal costs and a conceptual problem of justifying the procedure in face of the ?second best? theorem. Problems of this kind have led some economists to a rejection of correcting procedures altogether. They use market prices because they are easily observed and because the necessary adjustments themselves yield more costs than benefits. Others defend the use of marginal-cost pricing on grounds of pragmatism: in the absence of operational second- best pricing rules, some rule has to be adopted, and marginal-cost pricing has the best claim to acceptance.But marginal private cost will still not fulfill the role of a proper shadow price if private and social costs diverge. The most likely cause of divergence will be the presence of external effects. An external effect (or ?externality?) may exist in the form of cost or benefit.
An external cost will be a utility loss suffered by an individual or firm, the loss being uncompensated. The obvious reason for failure to compensate is the absence of property rights in economic goods such as clean air and unpolluted water. Similar problems arise with ?free? goods, such as road and air space. Notice that once a process of compensation does exist, the externality is ?internalized?. This does not mean that it ceases to exist altogether. Suppose the agent causing an external cost is required by law to pay compensation to the sufferer. As long as his marginal private benefits exceed the marginal losses of the sufferer, he can afford to pay the compensation and still have some net gains left over. After a point, the marginal losses may exceed the marginal gains, so that the process of compensation ceases to be economically viable.
The producer stops production at that point. He will still be paying compensation for losses suffered up to that point, however, so that some amount of externality still exists. There is in fact some ?Pareto-optimal? amount of externality which suggests that across-the-board legislation to eliminate an environmental nuisance may not be justified within the confines of Paretian welfare theory. In practice, of course, it would be difficult to assess the optimal degree of nuisance so that legislative measures may need to be undiscriminating.?Similar arguments apply to the generation of external benefits. Where these are ?unappropriated? the activity of the benefit-creating agency should be expanded, and market price will understate the true social benefit.
The issue for CBA is how to allow for externalities. The first and perhaps most obvious point is that external effects must be allowed for. Although some writers seem to regard externalities as being of little empirical relevance, it is difficult to avoid the impression that they are of considerable importance, as the seemingly endless reports of air, sea and river pollution, aircraft, industrial and road noise, and landscape and wildlife destruction demonstrate. Indeed, interference with the ecosystem in general will generate a chain reaction of external effects well beyond the normal time-horizons of planners, a problem which has attracted little real attention from economists to date. Second, having noted their existence and the form they may take, the decision-maker must decide whether to adjust his shadow prices or separately assess a social valuation of the externality.
The usual procedure is the latter. Third, and most important, since externalities are characterized by the absence of markets, there will also be an absence of observable prices with which the cost-benefit analyst can work. Many external effects problems therefore reduce to the issue of valuing 'intangibles'.